Bonds as an Investment Instrument

A bond is a fixed income investment in which an investor loans money to an entity (typically corporate or government) which borrows the funds for a defined period of time at a variable or fixed interest rate. Owners of bonds are debt-holders, or creditors, of the issuer.

Bonds are negotiable promissory notes that can be used by individuals, business firms, municipalities, state Governments or Government agencies to raise money and finance a variety of projects and activities. Bonds issued by the government or the public sector companies are generally secured. Private sector companies can issue secured or unsecured bonds. In case of a bond, the rate of interest is fixed and is known to the investors. A bond is redeemable after a specific period. The expected cash flows consist of annual interest payments plus repayment of principal.

Debt capital consists of mainly bonds and debentures. The holder of debt capital does not receive a share of ownership of the company when they provide funds to the firm. Rather, when a Company first issues debt capital, the providers of debt capital purchase a debenture, which involves lending money to the firm. In return for loan of this money, bondholders have a right to certain guaranteed payments during the life of the bond. For an illustration; a company issued a bond of a face value of Rs. 100 carrying a coupon rate of 5 per cent for 5 years. This entitles the bondholder to receive Rs. 5 (@5%) for 5 years as interest pay-off. At the end of 5th year, the bondholder is also entitled to receive back the invested amount of Rs. 100. Irrespective of the level of profits or losses, which company makes during this period of 5 years, the bondholder is entitled to receive the coupon interest during that period. If the company fails to pay the coupon interest or the redemption value, at the end of term, the bondholder may enforce their rights and lead the company into bankruptcy as per the procedure of law.

Risk : For an investor, debt capital is less risky but, earns a lower rate of return as compared to other forms of capital. Debt is cheaper than equity capital because there is lesser risks, it has a further advantage over equity capital, such as differential tax treatment of interest payments on debt and dividend payments on equity.

Tax implications : The interest paid on debt are tax-deductible, means that the interest payments are deducted from total income to arrive at the taxable income of the company. In contrast, dividend payments are not tax-deductible. Thus, two companies with identical operating incomes, but which differ in terms of their level of debt, will have different taxable incomes and therefore, different After Tax Income computation. Thus debt capital provides a ‘tax-shield’ which is not available in case of equity capital but this further lowers post-tax cost of debt of the firm.

As the debt capital has a lower cost than equity capital, a firm can lower its overall cost of capital by applying a judicious mix of Debt and Equity for its investment purposes, by changing the mix of debt and equity. The mix of debt and equity is known as the capital structure of the firm.

Characteristics of Bond

  • Face value is the money amount the bond will be worth at its maturity, and is also the reference amount the bond issuer uses when calculating interest payments. For instance, An investor purchases a bond at a premium at Rs.1,090 and another purchases the same bond at a discount at Rs.980. When the bond matures, both investors will receive the Rs. 1,000 face value of the bond.
  • Coupon rate is the specific rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage. For example, a 5% coupon rate means that bondholders will receive 5% x Rs.1000 face value = Rs. 50 every year.
  • Coupon dates are the dates on which the bond issuer will make interest payments. Typical intervals are annual or semi-annual coupon payments.
  • Maturity date is the specified date on which the bond will mature and the bond issuer will pay the bond holder the face value of the bond.
  • Issue price is the price at which the bond issuer originally sells the bonds.
  • Redemption Value: The value, which the bondholder gets on maturity, is called the redemption value. A bond is generally issued at a discount (less than par value) and redeemed at par.
  • Market Value: A bond may be traded on a stock exchange. Market value is the price at which the bond is usually bought or sold in the market. Market value may be different from the par value or the redemption value.

TYPES OF BOND

  • Zero-coupon bonds do not pay out regular coupon payments, and are issued at a discount and their market price eventually converges to face value at the time of its maturity. The discount a zero-coupon bond sells for will be equivalent to the yield of a similar coupon bond.
  • Convertible bonds are debt instruments with an embedded call option that allows bondholders to convert their debt into equity, at some point of time, if the share price rises to a sufficiently high level to make such a conversion attractive.
  • Fixed rate Bonds carry coupon rates which remain constant through-out the life of the bond. Whereas, Floating Rate Bonds or Floaters, carry a variable coupon rate which is usually linked to a reference rate of interest, such as LIBOR, MIBOR etc.
  • Junk Bond or High yield Bonds are rated below the investment grade by the credit rating agencies. As the risk involved are quite high as compared to investment grade Bonds, investors expect a relatively higher yield with it.
  • Inflation-Indexed Bonds assures repayment of principal and interest payments linked to inflation rate. On similar lines, Bands can be linked to other Indexes, such as equity-linked notes etc.
  • Subordinated Bonds are those with a lower priority than other Bonds of the issuer.
  • Perpetual bonds or Perps, are issued with no maturity dates.
  • Bearer Bonds do not carry the name of the beneficiary/name holder. These are issued with paper certificate with proper identification number to avoid counterfeiting, but these can be traded as cash and the holder shall be its bonafide owner. These are though very risky investment as it is exposed to the risk of theft or getting lost.
  • Some corporate bonds are callable, meaning that the issuer can call back the bonds from debtholders if interest rates drop sufficiently. These bonds typically trade at a premium to non-callable debt due to the risk of being called away and also due to their relative scarcity in the bond market. Other bonds are putable, meaning that creditors can put the bond back to the issuer if interest rates rise sufficiently.

These are excerpts of the few pages of e-book – Accounting & Finance For Bankers –  by N K Gupta.

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